Slides from Hayden Capital from the Corner of Berkshire & Fairfax meetup, titled, “Calculating Incremental ROIC’s.”
Why Should We Care About ROIC’s and Reinvestment Rates?
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy Read More
"Investing is an Art, not a Science"
- Many of the examples given here are theoretical. Often you won’t have all the information necessary to do the calculations –especially not down to the $0.01.
- This is simply a framework to think about these issues. It’s your job as an investor to fill in as much of the gap as possible, to hopefully see the bigger picture.
Reinvestment Rate: How Much Is The Company Investing In Itself?
Reinvested Earnings = Sustainable Earnings Power –Reported Earnings
Reinvestment Rate = Reinvested Earnings / Sustainable Earnings Power
- Sustainable Earnings Power is what the business would theoretically earn if it stopped growing.
- There no set “formula” for calculating this. It’s going to be industry & business model dependent.
- For example, a commodity business may structurally only earn it’s cost structure difference vs the next most efficient competitor.
- Alternatively, a one-of-kind, mission-critical software provider (think Microsoft in 90’s) has enormous pricing power.
- They could raise prices up to the point where new customers = lost customers.
- For the last marginal customer in this scenario, the Price = Customer’s Marginal Utility
- The better the reinvestment opportunities, the higher the reinvestment rate should be.
- If a company has unlimited opportunities to earn 50% returns, management better be plowing every cent back into the company, and reporting $0 EPS (assuming investments are expensed).
- Note: Some companies have a high return project, but limited capacity.
- A new factory may cost $5M, with 50% returns. But the business generates $20M a year… what do you do with the other 15M?
- Assuming the other 75% is returned, that’s only 12.5% growth.
- Lots of opportunities to deploy capital are just as important as the Return on Invested Capital.
Incremental Return on Invested Capital
Start with a Framework / Thesis (i.e.. a blank sheet of paper)
- Investing and “data-point” analysis is similar to coloring. You’re simply trying to fill in the dots (i.e. piece together knowledge) to see the end picture.
- For example, you think it could be a “wolf” (it’s what the directions say), but you’re skeptical… There’s no way to find out, until you start coloring.
- (“Wolf” in this case = an attractive business)
Find Data-points that Confirm or Deny the Thesis (i.e. Fill In The Dots)
- The picture’s starting to come together… there’s some sort of shape, but it’s still not clear.
- Some dots are outside the framework, but the majority seem to fit the outline.
- Why’s that look like a Giraffe though??
See the full PDF below.